Our two preceding columns exposed the weak arguments against expensing options, and then analyzed the incomplete methods that predated the Financial Accounting Standards Board’s March 2004 exposure draft. This one compares the proposed method with what we call the “liability method.”

The primary flaw in FASB’s proposal is its reliance on the old-fashioned matching model that was rejected in the board’s Conceptual Framework, because it calculates expense without paying attention to what happens to the real values of real assets and liabilities. As a result, FASB’s method will misrepresent the options’ total cost (equal to the difference between the strike price and the stock’s market value on the exercise date), fail to clearly unveil the dilutive effects of the option overhang, report more income tax expense than the company actually pays, and understate the equity created when the stock is issued.

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